Lessons Learnt from 4 Biggest Losses - Part 2

This is a continuation of the previous post lessons learnt from my 4 Biggest Losses. To recap they are: 

1. Overseas Education, negative c.30%, operator of one of the largest international schools in Singapore. Student enrollment and revenue fell continuously for almost 10 years. It was exacerbated by the pandemic but even if the world normalizes, it is unclear if the stock will rebound. Management are owners and exemplified small cap risks.

2. SIA Engineering, negative c.20%, aircraft maintenance arm of our national carrier. I overpaid for this and am now suffering. It is unclear if I can breakeven. Oversizing the position also caused outsized absolute losses. This is the ultimate reminder for me not to overpay and to size my bets well.

3. Under Armor, negative c.70%, this was a stock that got into the portfolio because of a structured product went wrong. I sold puts and it got exercised. After holding the stock, it continued to drop and was hit by the pandemic. While there is a chance it can go up 100% or more from here (the 40x gap between Under Armor's and Nike's market cap seemed too big), I am not betting on it. This is another lesson about valuation - never overpay!

4. Cinema related small cap name, negative c.80%, this is a Chinese cinema technology provider that was badly hit by the pandemic. It is also another small cap name which comes with it small cap risks, like Overseas Education. The lesson is therefore not to invest in too many small caps and/or if we must, demand a much higher valuation discount.

In a nutshell, the lessons learnt here are: sizing, small cap risk, understanding unknown risks and over-valuation. I have discussed about sizing and hence we shall touch upon the rest today.

Small cap: I would refer to stocks trading at lower than USD2bn market cap and this was the case with #1 and #4 above. Small caps are usually run by owners, less experienced management teams and the business revenue also tend to be more volatile and as such deserves lower valuations. But we tend to forget that and ascribe just a 10-20% valuation discount to a similar business which is much bigger. 

Courtesy of CME Group

Looking at the four names, we can also argue whether Under Armor (market cap USD3.9bn) truly has an investment case. It is small cap looking through the eyes of Nike (market cap USD147bn) and Adidas (market cap USD28bn). One is much better off buying Nike or Adidas. Why bother with the third smallish player? The chart above says it all - it shows returns between large cap and small cap are not really different yet small cap investors take on a lot more risks. As such, the lesson here is that perhaps we should just avoid small caps. 

Understanding the risks: This brings us to the second lesson. We think we have uncovered everything. We have done our homework well. But it is actually very difficult, especially with small caps and inherently volatile industries. I think there are no good advice (to myself and readers) here, it takes years of experience to understand some of these industries and I urge everyone to always have robust discussions with other smart thinkers. 

The case-in-point here is the cinema technology provider that I bought which has gone down 80%. We all go to cinemas and we think we know the industry well. But with Netflix and streaming disrupting the industry, let alone all the faster changes in China, the writings were on the wall that risks are mounting. When the pandemic hits such small cap names, it was game over. 

It was a similar story with SIA Engineering. I thought I got the investment thesis right. There will be a lot more middle income tourists in the world, Changi will build T4 and T5 and SIA Engineering will benefit. I discussed with smart friends and even though they said it is not water-tight, I refused to listen. Lo-and-behold the pandemic came and turned everything upside down. Looking back, the airline industry is just inherently volatile and it doesn't pay to put too much money into one name and let alone related names (yes, I have other related names!).

Over-paying: There are multiple mistakes with SIA Engineering. Not only did I read the industry wrongly, I overpaid for it at more than 20x PER at the time of buying. I did the same with the cinema name (25-30x PER), believing in the growth story. I also overpaid for Under Armor at more than 30x PER. So much so for proclaiming to be a value investor. But this is also portfolio-manager-wanting-action error. 

Swing you bum! - Courtesy of MyTrade PH

Sometimes, we are compelled do to things even when there is nothing that we should do. From 2016-2020, the market was overvalued and as such most stocks are over-valued. I thought I was getting bargains for getting these high growth names at 25-30x PER. After all, Amazon and Tesla did so well trading at even higher valuations right? Well, unfortunately, I didn't have those but had these! The related lesson is that not all sexy stocks are the same. So perhaps it was best to avoid high valuations, esp after triangulation, they are still high. Again it's easier said than done. The inner voice is constantly shouting "Swing you bum!"

To sum up this last lesson:

1. When everything is expensive, it pays to do nothing.

2. Don't think your growth stock is Tesla.

3. Do not overpay. 

Huat ah!

Lessons Learnt from 4 Biggest Losses - Part I

Most people brag about their investment wins. It is just human nature. We need to show we are better, so we get status, pride and get to lead and enjoy the benefits that get accrued to leadership in tribes. In prehistoric times, alpha males who can hunt, have muscles, can fight well tend to get the best food, the best shelter and the women and produce more offsprings and win the natural selection competition. 

As such, bragging is biological.

Alpha male primate can even get cookies!

Today, it is about money. You can be bald and fat but if you are a billionaire, then prestige and goodies and some women will come your way. So we brag about investment wins to showcase that. We buy cars, watches, houses and NFTs to display wealth. It is imperative, biologically and socially.  But what is truly and fundamentally beneficial is to learn from our losses. That is how we get better as investors. That is what this post and the next is about. 

As I look at my portfolio, there are now four big loss-making positions which I felt compelled to write about. The losses amount almost to six digits and you can imagine how it pains to write about them. But I believe there are many lessons learnt and I hope readers can really takeaway some of these so as not to repeat them. But trust me, it will be easier said than done! Here are the losers in no particular order:

1. Overseas Education, negative c.30%, I have blogged about this stock.

2. SIA Engineering, negative c.20%, pandemic victim, I have also briefly blogged about this.

3. Under Armor, negative c.70%, hit by overvaluation and the pandemic.

4. Cinema related small cap name, negative c.80%, looks like I will never recover my capital.

As I looked at the four painful names, I see similar mistakes and recurring lessons. While all four names were somewhat impacted by Covid-19, it was not just the pandemic. It was overpaying i.e. valuations, it was ignoring small cap risks and not understanding all the issues and most importantly, it was not getting the sizing right. Actually, sizing is so crucial so let's talk about that in more detail. 

What I got from Google wrt to sizing

For me, the sizing mistake relates to all four names but it had the biggest absolute damage in the first two. As such, despite the percentage loss was only 20-30%, the outsized impact on the absolute damage was big and this is the nutshell lesson about sizing:

We must size the bet such that we can still sleep if we lose 80% of the amount invested. We must also think in terms of percentage of the portfolio. In most professionally run portfolios, there are hard limits like 10% for one position but for personal accounts, we may want to size it lower depending on our own psychological construct and the amount of absolute loss we can bear.

Let's use so numbers to illustrate the above. First we must determine how much we can afford to lose in one position. I will arbitrary put that as S$40,000 which is close to half of Singapore's median household income. (Imagine when you need to tell your better half that you lost half a year's income on one stock. This should be good pyschological threshold ;) Looking at my actual losses, since a position can go down 80%, that means the maximum bet on one stock should be c.S$50,000. Of course that also depends on your portfolio. If this is more than 10% of your portfolio, then perhaps it should be smaller. 

There is also a minimum size for a position which relates to transaction costs. When I first started, round trip (buying and selling) transaction cost can cost minimally $100 which means that any position should be c.S$10,000 otherwise it doesn't make sense as it costs 1-2% every time you do some buying and selling. Well, the world has changed and transaction costs can go to zero with some brokers, but still, sometimes it's not and it pays to know what is the optimal minimal size for you.

Going back to my mistakes, if I sized the bets correctly, I could have reduce my absolute losses by half and the pain will also be halved and I would not have to endure the wrath of my better half! When you can size correctly, losses cannot hurt your portfolio and your family peace and you can sleep better at night. There is a lot more to talk about sizing which perhaps deserve its own post but let's stop here for today and we shall discuss in the next post:

1. Valuations 

2. Small cap issues

3. Unknown risks

There are two rules in investing. First rule: don't lose money. Second rule: don't forget the first rule.

Huat Ah!

Overseas Education Ltd - Part 2

This is a continuation from the previous post.

A quick recap: Overseas Education (OEL) operates one of the largest international schools in Singapore and was listed on SGX in 2013. The stock has since collapsed below its IPO price due to the three issues discussed previously.

1. It move from Orchard to Pasir Ris, a less prestigious location and lost 20% of its enrolment.

2. Competition has increased with now over 70 international schools in Singapore.

3. The global economic woes hit Singapore hard with lots of expats losing jobs and going home.

OFS senior year students

As alluded to in the previous post, these are likely short term issues that would be resolved in a few years. Yes, value investing is a game measured in years. While these issues could persist for say 18 months, it is likely to normalize over years. So for readers looking to play monthly or quarterly games, well, then, this post is not really suitable. Although these same readers would probably not mind ogling at picture of the senior year students provided here. So read on!

Just joking, the above is a pic taken from The Princess Diaries starring Anne Hathaway when she was 18, fifteen years ago. Today, she is more beautiful as Catwoman (shown below) but alas OFS students are even more beautifulier. This hopefully inspires some readers to go kick the tires by doing actual visits to Pasir Ris :) Anyways, back to long term thinking, here's the thing, if we look out in years, not months, enrolment should have bottomed. OFS has managed to grow enrolment steadily for the last 20 odd years. It is likely to keep growing if we are willing to look out a few years. On average, it has experienced net gain of 150-200 students per year over its long history. So hypothetically it should get back to pre-move enrolment of 3,600 in just three or four years.

Anne Hathaway today, looking more beautifulier

As for competition, while there are c.70 schools in Singapore, the top few schools command high market share with their capacity and brand name. These are the numbers: there are c.40,000 students but the top five schools accounts for c.50% of market share. This means that the remaining 65 schools are not actually competitors as they can hold only a few hundred students each. Simply put, they are barely a tenth or a fifth the size of OFS. In fact quite a few of these schools are struggling to survive. If they do close down, OFS stands to benefit from their transferring students.

The world economy has collapsed in 2015 in the aftermath of China's slowdown, the bursting of the commodity super cycle and the bleak recovery in US and Europe. Global expats are moving back to their home countries and Singapore had its fair share of such woes. Despite this, it was surprise to see that the number of employment pass holders actually jumped from 175,000 in 2013 to 188,000 in 2015, a nice 7% increase over two years. This points to Singapore's continued attractiveness as a global hub for expats to come and work. As long as Singapore remains relevant, the number international students will grow and OFS enrolment should grow over time even though current enrolment is still weak.

Next we move to the financials.

As part of its listing requirement, OEL has produced detailed financial statements since 2010. Again, not to be confused, Overseas Family School or OFS is the name of the school and Overseas Education Limited or OEL is the listed entity. We now have five years of detailed financial statements. Analysis of its profit and loss, balance sheet and cashflow is quite straightforward, given the simplicity of the business model. Here's the cheatsheet:

OEL's Cheatsheet

As usual, this cheatsheet plugs out some of the most important no.s from the three statements and put them in a nice format for easy reference. These are numbers not from any single year but a mixture of estimates and actual figures for better analysis. For example: Sales of SGD 100m is an estimate of what OEL can earn in the next 1-2 years while current year sales is only about SGD 94m. Cash and debt are rounded to the nearest 10m based on last reported numbers.

Numbers in blue are derived from other numbers. We can see that the firm has incredible free cashflow or FCF yield (14.6%), Operating margins (24%) and so-so ROE (11%) but likely to increase as its net income normalizes in the next few years. The P&L is simply revenue minus costs, the largest being labour cost which is 58% of sales. The balance sheet has quite a bit of debt (SGD 180m) as a result of the past borrowings to build the new campus but that should decline over time. Free cashflow turned negative as it poured money into building the new campus but that should also normalize and the firm would likely hit 20-25m FCF per year as it did before it moved from Orchard to Pasir Ris.

As part of the drilling in this post, we look closely at these three numbers described above in detail for this cheatsheet, namely:

1. Labour Cost
2. Debt to Equity
3. Free cashflow and dividend

OEL employs international school teachers globally and it pays to get quality. As such, labour cost ie teachers' salaries is the highest cost component and would likely continue to be so. The school has established itself as the employer of choice for the global pool of international school teachers. These teachers usually sign three year contracts and depending on the student enrolment trend of the school, some would not be renewed. Conversely, the school also has a list of potential new hires for it to recruit rapidly when enrolment picks up and it needs more educators. While labour cost by and large will keep increasing over time with inflation, the school can offset this by increasing tuition fees. The school currently keeps slightly more teachers that needed given that enrolment just collapsed but that should pick up as discussed previously. Over the next few years, we can expect labour cost as a percentage of sales to drop closer to 50%. In short the firm has some flexibility in managing labour cost and offsetting it.

Next, we discuss the conversion of its debt enterprise value to equity enterprise value. OEL raised its debt significantly in order to build its new campus, resulting in the current situation of SGD 120m in net debt (180m debt - 60m cash). Its Enterprise value (EV) stands at SGD 299m. EV being simply market cap plus net debt (179m + 120m). Now, the enterprise value of the firm shouldn't change if the business is intact. So this means that as the firm generates cash annually to pay down its debt, eventually paying it to zero and attaining a net cash status as it has done so in the past, its EV should equate its market cap. This means that its market cap should jump from current SGD 179m to 299m ie up by 67% over time.

This is only possible if the firm keeps generating cash to pay down its debt. For OEL, well, it seems to work just perfectly alright. The firm is capable of generating SGD 20-25m of free cash flow per year, in fact, in the cheatsheet, it's even higher at 26m. This translates to an incredible 14.6% FCF yield, something as safe as a school rarely trades so cheaply. Even if we assume a more conservative number, say it can only do SGD 15m, it still translates to a decent 8.4% FCF yield and bearing in mind that it would use this 15m to pay down its debt means its market cap would grow by the same quantum per year ie 15m or 8.4% of 179m.

To sum this up, in a pretty bad scenario where things simply remain the same, OEL grows at a high single digit clip. If our thesis is right ie enrolment comes back, on top of the regular tuition fee increases, OEL is on its way to see its previous peak $1.02 (2.5x vs current price) and meanwhile we also get 4% dividend every year while it grows multifolds!

Disclaimer: this author owns OEL!

Overseas Education Ltd - Part 1

Part 2 is out!

Overseas Education Ltd (Bloomberg Ticker: OEL SP) is an intriguing small cap stock in Singapore listed in 2013 that almost doubled but then crashed spectacularly in the last 1.5 years. It now trades at 12% free cashflow yield, 11x PE and pays a 4% dividend (likely to be more going forward) and earnings are stable and growing barring Singapore's demise (i.e. our beloved little red dot one day becoming irrelevant).

For the uninitiated, OEL operates the largest independent international school in Singapore called Overseas Family School (OFS) providing expatriate kids with quality international education. It started in 1991 and currently has enrolment of 3,000 students. It is the third largest international school in Singapore after the Singapore American School (SAS) and the United World College (UWC). However, as it has no affiliation to any nationality, it is also the school with the most diversity in the world, boasting a record of educating kids from over 70 countries in our little red dot.

Well then, why did the stock collapse in the first place?

This was largely caused by its move from the prime downtown Orchard campus to Pasir Ris in 2015. It lost 20% of its enrolment and together with anxiety in the stock market since the start of 2016, OEL found no buyers for its stock. It is also likely that some large foreigner shareholders could be selling to get out of their positions which put further pressure on the stock price. Now, to me, this looks like the perfect scenario when value investors should pounce and buy when others are fearful and wait for the stock to go 2x (or even 3x) in a few years.

Well, let's not get too excited. To be fair, the bear story has a few valid points:

1. Losing the Orchard location was devastating, it lost 600-800 students with some in their early years which meant a lot of lost future income. But this is now all factored in the price.

2. Singapore has seen a huge increase in international schools and competition is intense. Last count there were over 70 international schools albeit some are quite small. There is now no longer any waiting list even at the top schools, this meant that Overseas Family School is facing a lot more competition.

3. The weakness in the global economy has translated to a lot of expats losing jobs in Singapore, which exacerbated the decline in enrolment numbers that we saw. These jobs include functions in the oil and gas industry, finance and managerial positions that might not be replaced soon. This meant less expats and their families staying in Singapore for the next few years.

We shall come back to these points later. First let's examine the bull case:

Education is one of the most fantastic businesses because the schools have a lot of pricing power. Parents are not about to be stingy when it comes to their children's education. They will pay an arm and a leg for good quality education especially if the school is "branded". Brand is very important and once built, its reputation lasts for decades (think Oxford, Harvard, Qinghua and in Singapore, Raffles and Hwa Chong) which meant that competition is actually largely irrelevant. Costs are relatively stable (teachers and depreciation essentially) and easily managed and offset by rising school fees which meant that marginal profitability is very high once the fixed cost is covered. 

OFS has been slowing building its brand name in Singapore for twenty over years albeit it has always been outshined by the Singapore American School, UWC, Tanglin Trust, Canadian and some others with affiliations to their home countries. Over time, however, it should slowly build stronger reputation given its dedication in hiring the best teachers and its sheer size and outreach in Singapore. It is well-known in the global recruitment of overseas teachers as one of the best employers globally. Hence its should have the ability to grow and retain its talent pool of teachers and continue to build its brand power.

Anecdotally, expat mums also like to share that their kids enjoy and learn a lot in the school and would not want to be transferred to some of the other top brands despite the school's low key profile. As a result of its diligence in hiring good teachers, emphasizing quality and good management of its strong executive team, it's enrolment had grown steadily from 200 students in its second year of operation to over 3,000 students today as shown in the chart below until 2013 (when enrolment peaked at 3,600 students). 

Overseas Family School Enrolment

OFS' test results have also improved over the years as a natural consequence of its focus on providing good holistic education. It has gradually nurtured more and more students getting more than 40 points out of the full marks of 45 in the globally recognized International Baccalaureate (IB) test. While it still has some distance from the three Singapore schools offering IB to Singaporean students (with c.25-50% of students getting 40 points or more), its test results are remarkable considering it does not have the advantage of nurturing most of its students for more than a few years since expats move around a lot to different global cities all the time.

Hence while OFS had seen a dramatic decline in enrolment as a result of its move to Pasir Ris, it should continue to grow as long as Singapore remains relevant economically and can attract global expats to live and work here. OFS should see net enrollment growing by 150-200 students or so which mean that it should take just 3-4 years for it to recover its enrolment to the 2013 level. From there the school could grow to fill up its campus capacity of more than 4,000 students at its new location over time.

One important point is this: even if enrolment growth is slower than expected, education, especially international school education, is a business that would see 5-6% price increase annually. This means that its FCF of S$20m currently should be the bottom because even without increasing enrolment, one should expect a base case scenario of its FCF growing 5-6% on school fees increase alone. Obviously there is quite a good likelihood that Singapore remains a magnet for expats, i.e. the number of students would increase by 5-7% per year (150-200 out of 3,000) and FCF explodes to S$30-40m by growing 10-15% over the next few years. At S$170m market cap today, this stock is a steal!

Next post, we look into more details surrounding its financials and the risks.

Disclaimer: The author of this post owns OEL!